Special Report: Making forests pay in a warming world

SEMPIT, Indonesia (Reuters) - Deep in the flooded jungles of southern Borneo, muddy peat oozes underfoot like jello, threatening to consume anyone who tries to walk even a few yards into the thick, steaming forest.

Hard to imagine this brown, gooey stuff could become a new global currency worth billions a year, much less an important tool in the fight against climate change.

Yet this is a new frontier for business, says Bali-based consultant Rezal Kusumaatmadja, and a new way to pay for conservation efforts in a world facing ever more pressure on the land to grow food and extract timber, coal and other resources.

He and his fellow Indonesian business partner Dharsono Hartono are trying to preserve and replant a peat swamp forest three times the size of Singapore in Central Kalimantan province in Indonesia's part of Borneo. And in the process, draw in local communities by boosting livelihoods and curb encroachment

They are at the vanguard of a global effort to slow climate change by trying to create a new market that puts a value on preserving forests, or avoiding deforestation.

The effort brings together a diverse cast of characters: environmental entrepreneurs such as Kusumaatmadja and Hartono; investment bankers trying to create a carbon market; companies seeking to buy carbon credits in that market; activists trying to ensure some of that money flows to rainforest communities; and bureaucrats whose task will be to somehow monitor and enforce the ambitious scheme, and not divert the proceeds into their pockets.

Rainforest preservation has become central to U.N. talks on a tougher climate pact and is a focus of a major climate conference in Cancun, Mexico, that began on November 29.

The key is carbon. Forests, and particularly deep peat forests in the tropics, soak up and lock away lots of carbon dioxide, the main greenhouse gas, acting like giant filters for the atmosphere. Cut down the forests and drain the peat, and they can release even more. Deforestation and burning account for more than half Indonesia's greenhouse gas emissions, making it leading carbon polluter.

How, then, to put a price on that carbon and trade it?

That's the puzzle and the lure for many investors who want to capture the benefits forests bring, from locking away carbon, to being watersheds for rivers and storehouses of countless species.

"You can't solve the climate change issue unless you simultaneously tackle deforestation," said Abyd Karmali, global head of carbon markets for Bank of America Merrill Lynch. That means preserving what's left and driving investment in rainforests in Brazil, Democratic Republic of Congo and Indonesia, which have the three largest areas of remaining tropical forests.

But the plan pits powerful business interests in the palm oil, logging and mining sectors against public and private sector efforts to support greater forest protection and potential carbon credit payment systems. It also means reforming powerful bureaucracies and weeding out entrenched corruption, strengthening land ownership and land use rules, improving monitoring and law enforcement and enshrining the rights of local forest communities.

PEAT PRESERVATION

In some countries, including Indonesia, the reform process is under way, and daunting though the challenges may be, rich nations such as Norway have already pledged in total about $4 billion for pilot programs to drive such reforms.

Studies such as the 2006 Stern Review, and investors such as George Soros, say saving forests is a cheap way to buy mankind a little more time in the switch to less polluting economies.

The scale of the challenge -- and the potential benefits -- is vast.

Borneo, the world's third largest island, has lost half its forest cover in a matter of decades. Every year, peat swamp forests and soil storing up to 1 billion tons of CO2 are destroyed in Indonesia. U.N. data shows the annual rate of deforestation in Indonesia is about 700,000 ha a year, less than half the level from the 1990s, but still 10 times the size of Singapore.

To give a sense of scale, 12 percent of Indonesia's land area is peatland. Yet this area is a repository for more than 40 billion tons of carbon (more than 100 billion tons of CO2 if released), according to Dutch research institute Deltares.

This is more than twice mankind's annual -- and growing --greenhouse gas emissions. It highlights the threat posed by clearing peat swamp forests, and why Indonesia has become a key player in the efforts to revalue forests in poorer nations.

"Carbon credits from forestry is a new way to finance conservation efforts, such as restoration, or preservation," Kusumaatmadja told Reuters in the trading town of Sampit in Central Kalimantan during a recent trip to the 227,000 ha (570,000 acre) peat forest conservation project in Katingan regency (county).

"You also need to work with communities to build up livelihoods so they don't encroach," he said.

Ultimately, the battle will come down to forests being worth more standing than cleared for a plantation -- and then getting buy-in from local communities.

"What you need to have is proof of concept," says Kusumaatmadja, 40, the son of a former Indonesian environment minister and who trained as an urban and regional planner in the United States. "This means we deliver the emissions reductions and get compensated. Then we can start talking about the competing values for the land. Because right now there is no value. It's a frontier. It's like people take a leap of faith that this is actually making money."

Land tenure and the new science of carbon accounting, are additional challenges, he said, pointing to the need to have clear legal title to the carbon stocks in a forest and a legally enforceable process to resolve conflicts over land use.

Getting the carbon measurements right also will be crucial if investors are to trust a project's CO2 reductions.

READY FOR REDD?

At a point marked "D206" inside the Katingan forest, Kusumaatmadja, his team and this reporter gingerly make our way to a sampling site under several feet of water.

The site is to be one of about 400 planned across the Katingan project, with the aim of taking regular samples of peat depth, the amount of carbon stock above ground, such as trees, and the depth of the water that helps preserve the peat. The muddy, tiring work in mosquito-infested waters has shown the peat depth to be from one meter to about 12 meters across the project, shaped like an oval and 120 km (70 miles) end to end.

More than one billion of tons of carbon could be sitting underground, the result of millennia of carbon accumulation by the forest. But this could be undone in a matter of decades by clearing and draining the tea-colored swamps and burning the peat.

The resulting forest fires, blamed on oil palm plantation companies and local slash-and-burn agricultural practices, create a choking haze that regularly blights great swathes of Southeast Asia, much to the irritation of Indonesia's neighbors.

The Katingan project could generate about 100 million carbon credits over 30 years, depending on final carbon stock measurements. That's the same as 100 million tons of CO2 being locked away because the forest has been protected from being cleared, dry-season fires prevented and logged areas replanted.

Crucially, a portion of any credit sales would flow to local communities and central government coffers.

But to maximize the benefits, investors need a market.

"We cannot be sustainable in five years without a market for the credits," Kusumaatmadja's business partner Hartono, 36, told Reuters in Jakarta. "We're fighting a losing battle if there's no transaction," said the U.S.-trained former investment banker for J.P. Morgan, who runs private firm PT RMU. More than $2 million had already been invested in the project, he added, with another $4.5 million to be paid up front when the central government issues a special license.

Underpinning hopes for that new market is a U.N.-backed scheme called REDD, or reducing emissions from deforestation and forest degradation.

The idea is to reward developing nations that preserve their forests, boost the carbon stock, and have sustainable forestry management. Kusumaatmadja and Hartono's project is one of nearly 40 early REDD prototypes, the Indonesian government says.

Those rewards would ultimately take the form of an annual sale of forest carbon credits to rich nations to help them meet part of their mandatory emissions reduction targets in market that could be worth $30 billion a year, the U.N. REDD program estimates.

That's the theory.

Two years ago it seemed to be falling into place with the United States and Australia proposing domestic emissions trading schemes that would have allowed companies to use large amounts of offsets from overseas. Legislation to enact those schemes foundered in both countries, however.

Only Europe and New Zealand currently have emissions trading schemes, but the EU bars use of REDD credits and it is unclear if it will allow them to be used in the third phase of its trading scheme from 2013.

U.N. talks are far from sealing a broader climate pact to expand or replace the existing Kyoto Protocol from 2013 , in which REDD would be a central part, casting yet more uncertainty over the plan.

That leaves the newly passed California emissions trading scheme and a planned bilateral carbon offset program by Japan as the only real potential buyers at the moment.

The lack of major demand for credits comes as an irony, since over the past two years, governments and institutions, including the World Bank, have stepped in to finance pilot REDD projects in developing countries in Asia, South America and Africa.

The voluntary carbon market has also developed rigorous standards for projects to ensure the carbon reductions are real, measurable and verifiable to give investors confidence.

"Two years ago, mainstream investors didn't want to get involved in projects that appeared to be run by cowboys with ridiculous return expectations," said Chris Knight, assistant director of PricewaterhouseCoopers' climate change, forestry and ecosystems advisory.

Now, because of much improved standards, investors are less concerned about the risk at the project level, he told Reuters last month by telephone during a REDD conference in Malaysia.

Instead, investors are looking for more certainty over demand for the carbon credits, said London-based Knight, who is working on ways to draw in private-sector financing until there are stronger REDD policies in place in developing countries.

Some banks, such as Bank of America Merrill Lynch and Australia's Macquarie, have invested in projects or bought credits once projects pass a tough auditing process. Macquarie, in a 2009 report, estimated the potential emissions reductions from reducing deforestation at two billion tons of CO2 by 2030 and 1.3 billion tons for reforestation.

Karmali of Bank of America Merrill Lynch signed an agreement in early 2008 to buy carbon credits from a 750,000 ha project in Indonesia's Aceh province that aims to cut deforestation in the Ulu Masen forest area by 85 percent.

A deal with the government of Aceh in northern Sumatra and Singapore-based firm Carbon Conservation aims to reduce 100 million tons of emissions over 30 years and boost local livelihoods to prevent logging.

The credits, though, are still some way off, with the project still to complete the carbon auditing process by the respected Voluntary Carbon Standard based in Washington. But the project has already been approved by the equally respected Climate, Community and Biodiversity Alliance standard.

Karmali said it was essential to reward early action by REDD investors. It was also essential for the public sector to leverage private capital to drive investments in the forestry sector that would ultimately prove to be a cheap way of cutting greenhouse gas emissions.

"The other thing you could do is you could have a purchaser of credits of last resort," he told Reuters from London. This was an idea raised in the 2008 Eliasch Review for the British government. That report estimated that doing nothing to halt deforestation could lead to climate change costs to the global economy of $1 trillion a year by 2100.

Karmali pointed to the need to have some sort of global public sector fund that could buy up emissions reductions.

"If such a mechanism were deployed, it would be de-risking private capital," he said.

A BRIDGE TO FINANCE

For project developers, time is running out. East of PT RMU's Katingan project in Central Kalimantan, Hong Kong-based Infinite Earth is hoping its Rimba Raya project will be the first REDD investment to be fully validated by the Voluntary Carbon Standard by the end of this year, subject to the Indonesian government granting it a special license.

The nearly 100,000 ha project on the edge of a national park has forward-sold enough credits to cover operations for the next five years, but at a substantial discount to the 5 to 7 euros per carbon credit mentioned by brokers.

"Appetite for Rimba Raya credits has been good but definitely we need a compliance (emissions trading) market to support the prices REDD needs in order to be competitive with alternate land uses, such as palm oil," Infinite Earth CEO Todd Lemons told Reuters.

Knight of PwC said some sort of bridging financing or guarantee mechanism was crucial for investors until a global market evolved. "Unless you provide some sort of bridging finance before there's regulatory certainty then the risks are just too high for the private sector," Knight said.

One possibility was to ramp up the use of environment funds to help disburse some of the billions of dollars pledged by rich nations for REDD. These are often endowment funds and therefore independent of governments. Another was revolving funds, in which a portion of any REDD credit proceeds are returned to the fund to keep it running.

In the interim, large amounts of public money from governments, foundations and conservation groups are vital.

Earlier this year, dozens of nations teamed up to create an interim REDD partnership to guide spending of about $4 billion in pledged funding, build institutions and develop pilot projects between 2010 and 2012. To date, more than 70 nations have signed up.

Billionaire investor George Soros has also stepped in.

In a letter to U.S. President Barack Obama on Aug 21 this year following a trip to Indonesia, Soros said $10 billion a year would be sufficient to put a price on avoiding and reversing carbon emissions from rainforests.

He proposed a 5 percent surcharge on airline tickets, about 40 percent of which would go to the collecting countries and the rest to setting up a global forest fund.

Soros said he was willing to take on "exceptional first-of-a-kind risk" to send a positive signal to other private investors, but only under conditions that could bring in the required scale of private capital.

"These conditions would be tailored to the individual projects, but it is estimated that the cost would be less than $5 a ton of CO2 for a limited number of years for carbon savings that would extend over many more years," he said in the letter obtained by Reuters.

THE $1 BILLION CARROT

Earlier this year, Norway and Indonesia signed a climate deal worth up to $1 billion over the next five to six years, aimed at reforming Indonesia's notorious bureaucracy and funding pilot forest and peatland projects that cut carbon emissions.

Norway would pay for emissions reductions from projects that were measurable and verifiable, but believes a market-based system that trades forest carbon credits is some way off.

Under the Norway deal, Indonesia would impose a two-year moratorium on new licenses to cut down primary forests and clear peatlands, and set out clearer definitions of forest and degraded lands to prevent loopholes that could be exploited by companies.

The Indonesian government has created a special REDD task force, and appointed veteran technocrat Kuntoro Mangkusubroto to make the Norway deal a success. But some groups, including Greenpeace, while welcoming the deal, feel the reform process is being rushed and that a market isn't necessary at present.

"We see Indonesia and countries in that position of needing to spend a lot more time on building their technical capacity, their institution frameworks," said Paul Winn, Sydney-based forest and climate campaigner for Greenpeace.

Mangkusubroto, respected for his role in managing a multi-billion dollar reconstruction agency for Aceh province after the 2004 tsunami, relishes the chance to reform the bureaucracy. "It'll be excellent for Indonesia," he said with a smile during a recent interview in his office in the presidential compound in Jakarta.

The country needed to overhaul its land licensing process, refine its land maps, create a central agency to manage REDD projects and a system to accurately measure the nation's carbon emissions and any reductions, he said.

But he voiced fears about corruption.

"The poor people are easy to buy," he said, pointing to the power of big corporations. He also said there would be "leakage" at the local official level if the money from REDD credit sales flowed through regional governments via budgets.

"How do you structure a mechanism so that the money flows to the people? That's why we have to have pilot projects to monitor the flow of money. We haven't had that experience before," he said.

SHARING THE BENEFITS

Resolving land use and ownership conflicts is also key to Indonesia and other developing nations pushing ahead with REDD. Investors ultimately want to know who owns the carbon stock.

"Some conflicts are legitimate, some are not legitimate. Some are colored by bribery, some are genuine problems of lack of legal system coherence in our regulations," said Agus Purnomo, the Indonesian president's special climate change envoy.

The key was creating a dispute resolution mechanism that was legally robust, he said during an interview in his black Toyota Prius during a drive through central Jakarta.

Fair sharing of the benefits of REDD credits was also crucial to avoid disputes and encourage investors.

"The real elephant in the room is benefit-sharing mechanisms," said Stewart Maginnis of the International Union for Conservation of Nature. "You've got countries moving ahead putting in place procedures," to build up REDD, he said from Gland, Switzerland, after just returning from a grassroots meeting on REDD in Cambodia.

"There hasn't really been a (look) at how the money will flow from the capital city down to where the REDD initiatives are taking place, and then critically also, how it will flow horizontally within that locality. Who benefits?" he asked.

Rural communities' dependency on forests was also something that governments and donors were underestimating, Maginnis, director of the IUCN's environment and development group, said.

In the village of Mentanya Seberang on the riverbank opposite Sampit in Central Kalimantan, residents supported the nearby Katingan project but they also need long-term incomes from cash crops such as rubber, rattan and tree sap used in chewing gum.

"We support rubber planting and also rattan so that our forest won't be finished. If you talk about palm oil, that means the forest will be cut down," said Murniah, 40.

Kusumaatmadja and Hartono have spent the past two years working with an Indonesian NGO to discuss villagers' needs and potential livelihood benefits.

Deep inside the project, the needs are palpable. It doesn't take long to hear the sounds of chain saws from small teams illegally cutting trees into planks.

Some of the loggers are locals trying to earn a little extra cash, and local businessmen keen to supply timber for construction are only too happy to offer them work.

Mastranhani, 50, took up illicit logging to pay debts because an unusually wet year meant he couldn't grow enough rice to feed his seven children. The $100 or so each month he gets from logging is just enough for his family.

For other illegal loggers that Reuters met, the story was the same. Kusumaatmadja said finding employing and alternative livelihoods was crucial for the project to succeed.

So, too, is long-term demand for credits.

"Long-term stable demand is what's needed to make REDD viable and for that we need REDD to be included in the European carbon trading scheme, as well as Japan and ideally in the United States," said Lemons of Infinite Earth.

Until that happens, most fund managers would sit on the sidelines, he added.

Karmali said he was willing to wait. "These are all the niches of demand that could yet come," he said, referring to Japan and Australia. "That's why that we're still very committed to making sure the early projects that we're involved in, including Ulu Masen, continue to succeed, even if it does take a bit longer. Everyone has to just recognize this is going to be a marathon and not a sprint." (Additional reporting by Lewa Pardomuan; Editing by Bill Tarrant)